Chapter 12

Chapter 12
The Bond Market

Chapter Preview
In this chapter, we focus on longer-term

securities: bonds. Bonds are like money
market instruments, but they have maturities
that exceed one year. These include Treasury
bonds, corporate bonds, mortgages, and the
like.
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Chapter Preview
• Purpose of the Capital • Corporate Bonds

Market • Financial Guarantees
• Capital Market for Bonds
Participants • Current Yield
• Capital Market Trading Calculation
• Types of Bonds • Finding the Value of
Coupon Bonds
• Treasury Notes and
Bonds • Investing in Bonds
• Municipal Bonds

Purpose of the Capital Market
• Original maturity is greater than one year,

typically for long-term financing or
investments
• Best known capital market securities:
─ Stocks and bonds

Capital Market Participants
• Primary issuers of securities:

─ Federal and local governments: debt issuers
─ Corporations: equity and debt issuers
• Largest purchasers of securities:
─ You and me

Capital Market Trading
1. Primary market for initial sale (IPO)

2. Secondary market
─ Over-the-counter
─ Organized exchanges (i.e., NYSE)

Types of Bonds
• Bonds are securities that represent debt

owed by the issuer to the investor, and
typically have specified payments on specific
dates.
• Types of bonds we will examine include
long-term government bonds (T-bonds),
municipal bonds, and corporate bonds.

Types of Bonds:
Sample Corporate Bond
Figure 12.1 Hamilton/BP Corporate Bond

Treasury Notes and Bonds
• The U.S. Treasury issues notes and bonds to

finance its operations.
• The following table summarizes the maturity
differences among the various Treasury
securities.

Treasury Notes and Bonds
Table 12.1 Treasury Securities

Treasury Bond Interest Rates
• No default risk since the Treasury can print

money to payoff the debt
• Very low interest rates, often considered the
risk-free rate (although inflation risk is still
present)

Treasury Bond Interest Rates
Figure 12.2 Interest Rate on Treasury Bonds and the Inflation Rate,
1973–2013 (January of each year)

Treasury Bond Interest Rates:
Bills vs. Bonds
Figure 12.3 Interest Rate on Treasury Bills and
Treasury Bonds, 1974–2013 (January of each year)

Treasury Bonds:
Recent Innovation
• Treasury Inflation-Indexed Securities:

the principal amount is tied to the current
rate of inflation to protect investor
purchasing power
• Treasury STRIPS: the coupon and principal
payments are “stripped” from a T-Bond and
sold as individual zero-coupon bonds.

Treasury Bonds: Agency Debt
• Although not technically Treasury securities,

agency bonds are issued by government-
sponsored entities, such as GNMA, FNMA,
and FHLMC.
• The debt has an “implicit” guarantee that
the U.S. government will not let the
debt default. This “guarantee” was clear
during the 2008 bailout…

The 2007–2009 Financial Crisis:
Bailout of Fannie and Freddie
• Both Fannie and Freddie managed their

political situation effectively, allowing them
to engage in risky activities, despite
concerns raised.
• By 2008, the two had purchased or
guaranteed over $5 trillion in mortgages or
mortgage-backed securities.

• Part of this growth was driven by their

Congressional mission to support affordable
housing. They did this by purchasing
subprime and Alt-A mortgages.
• As these mortgages defaults, large losses
mounted for both agencies.

• In 2013, Fannie Mae repaid $59.4 billion of

its $117 billion in bailout.
• Freddie Mac has paid back about $37 billion
of the $72 billion it received.

Municipal Bonds
• Issued by local, county, and state

governments
• Used to finance public interest projects
• Tax-free municipal interest rate = taxable
interest rate  (1  marginal tax rate)

Municipal Bonds: Example
Suppose the rate on a corporate bond is 9%

and the rate on a municipal bond is 6.75%.
Which should you choose?
Answer: Find the marginal tax rate:
6.75% = 9%  (1 – MTR), or MTR = 25%
If you are in a marginal tax rate above 25%,
the municipal bond offers a higher after-tax
cash flow.


Which should you choose? Your marginal tax
rate is 28%.


Which should you choose? Your marginal tax
rate is 28%.
Find the equivalent tax-free rate (ETFR):
ETFR = 5%  (1 – MTR) = 5%  (1 – 0.28)
The ETFR = 3.36%. If the actual muni-rate is
above this (it is), choose the muni.

Municipal Bonds
• Two types
─ General obligation bonds
─ Revenue bonds
• NOT default-free (e.g., Orange County
California)
─ Defaults in 1990 amounted to $1.4 billion in this
market

Municipal Bonds: Comparing Revenue
and General Obligation Bonds
Figure 12.4 Issuance of Revenue and General Obligation
Bonds, 1984–2012 (End of year)

Corporate Bonds
• Typically have a face value of $1,000,

although some have a face value of $5,000
or $10,000
• Pay interest semi-annually

Corporate Bonds
• Cannot be redeemed anytime the issuer

wishes, unless a specific clause states this
(call option).
• Degree of risk varies with each bond, even
from the same issuer. Following suite, the
required interest rate varies with level
of risk.

Corporate Bonds
• The degree of risk ranges from low-risk

(AAA) to higher risk (BBB). Any bonds rated
below BBB are considered sub-investment
grade debt.

Corporate Bonds: Interest Rates
Figure 12.5 Corporate Bond Interest Rates, 1973–2012
(End of year)

Characteristics of Corporate
Bonds
• Registered Bonds
─ Replaced “bearer” bonds
─ IRS can track interest income this way
• Restrictive Covenants
─ Mitigates conflicts with shareholder interests
─ May limit dividends, new debt, ratios, etc.
─ Usually includes a cross-default clause

Characteristics of Corporate
Bonds
• Call Provisions
─ Higher required yield
─ Mechanism to adhere to a sinking fund provision
─ Interest of the stockholders
─ Alternative opportunities
• Conversion
─ Some debt may be converted to equity
─ Similar to a stock option, but usually more limited

Corporate Bonds: Characteristics
of Corporate Bonds
• Secured Bonds
─ Mortgage bonds
─ Equipment trust certificates
• Unsecured Bonds
─ Debentures
─ Subordinated debentures
─ Variable-rate bonds

Corporate Bonds: Characteristics
of Corporate Bonds
• Junk Bonds
─ Debt that is rated below BBB
─ Often, trusts and insurance companies are not
permitted to invest in junk debt
─ Michael Milken developed this market in the mid-
1980s, although he was subsequently convicted
of insider trading

Corporate Bonds: Debt Ratings
(a)
Table 12.2 Debt Rating Descriptions

Corporate Bonds: Debt Ratings
(b)
Table 12.2 Debt Rating Descriptions

Financial Guarantees for Bonds
• Some debt issuers purchase financial

guarantees to lower the risk of their debt.
• The guarantee provides for timely payment
of interest and principal, and are usually
backed by large insurance companies.

Financial Guarantees for Bonds
• As it turns out, not all guarantees actually

make sense!
─ In 1995, JPMorgan created the credit default
swap (CDS), a type of insurance on bonds.
─ In 2000, Congress removed CDSs from any
oversight.
─ By 2008, the CDS market was over $62 trillion!
─ 2008 losses on mortgages lead to huge payouts
on this insurance.

Bond Yield Calculations
• Bond yields are quoted using a variety of

conventions, depending on both the type of
issue and the market.
• We will examine the current yield calculation
that is commonly used for
long-term debt.

Bond Current Yield Calculation
What is the current yield for a bond with a

face value of $1,000, a current price of
$921.01, and a coupon rate of 10.95%?
Answer:
ic = C / P = $109.50 / $921.01 = 11.89%
Note: C ( coupon) = 10.95%  $1,000
= $109.50

Finding the Value of Coupon
Bonds
• Bond pricing is, in theory, no different than

pricing any set of known cash flows.
• Once the cash flows have been identified,
they should be discounted to time zero at an
appropriate discount rate.

Bonds
Table 12.3 Bond Terminology

Bonds
Let’s use a simple example to illustrate the

bond pricing idea.
What is the price of two-year, 10% coupon
bond (semi-annual coupon payments) with a
face value of $1,000 and a required rate of
12%?

Bonds
Solution:
1. Identify the cash flows:
─ $50 is received every six months in interest
─ $1000 is received in two years as principal
repayment
2. Find the present value of the cash flows
(calculator solution):
─ N = 4, FV = 1000, PMT = 50, I = 6
─ Computer the PV. PV = 965.35

Investing in Bonds
• Bonds are the most popular alternative to

stocks for long-term investing.
• Even though the bonds of a corporation are
less risky than its equity, investors still have
risk: price risk and interest rate risk, which
were covered in chapter 3

Investing in Bonds
Figure 12.6 Bonds and Stocks Issued, 1983–2012

Chapter Summary
• Purpose of the Capital Market: provide

financing for long-term capital assets
• Capital Market Participants: governments
and corporations issue bond, and we
buy them
• Capital Market Trading: primary and
secondary markets exist for most securities
of governments and corporations

Chapter Summary (cont.)
• Types of Bonds: includes Treasury,

municipal, and corporate bonds
• Treasury Notes and Bonds: issued and
backed by the full faith and credit of the
U.S. Federal government
• Municipal Bonds: issued by state and local
governments, tax-exempt, defaultable.

• Corporate Bonds: issued by corporations

and have a wide range of features and risk
• Financial Guarantees for Bonds: bond
“insurance” should the issuer default
• Bond Current Yield Calculation: how to
calculation the current yield for a bond

• Finding the Value of Coupon Bonds:

determining the cash flows and discounting
back to the present at an appropriate
discount rate
• Investing in Bonds: most popular alternative
to investing in the stock market for long-
term investments

Chapter 12 - The Bond Market

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Chapter 12 - The Bond Market

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The Bond Market

In this chapter, we focus on longer-term

Copyright ©2015 Pearson Education, Inc. All rights reserved. 12-1

• Purpose of the Capital • Corporate Bonds

Copyright ©2015 Pearson Education, Inc. All rights reserved. 12-2

• Original maturity is greater than one year,

Copyright ©2015 Pearson Education, Inc. All rights reserved. 12-3

• Primary issuers of securities:

Copyright ©2015 Pearson Education, Inc. All rights reserved. 12-4

1. Primary market for initial sale (IPO)

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• Bonds are securities that represent debt

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Figure 12.1 Hamilton/BP Corporate Bond

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• The U.S. Treasury issues notes and bonds to

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Table 12.1 Treasury Securities

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• No default risk since the Treasury can print

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• Treasury Inflation-Indexed Securities:

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• Although not technically Treasury securities,

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• Both Fannie and Freddie managed their

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• Part of this growth was driven by their

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• In 2013, Fannie Mae repaid $59.4 billion of

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• Issued by local, county, and state

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Suppose the rate on a corporate bond is 9%

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Suppose the rate on a corporate bond is 5%

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Suppose the rate on a corporate bond is 5%

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• Typically have a face value of $1,000,

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• Cannot be redeemed anytime the issuer

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• The degree of risk ranges from low-risk

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• Some debt issuers purchase financial

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• As it turns out, not all guarantees actually

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• Bond yields are quoted using a variety of

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What is the current yield for a bond with a